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There's a New Curve in Town and It's Flashing Red, Gavekal Says

(Bloomberg) -- The private sector may hold the real clues to recession risk.

While the flattening U.S. yield curve -- the difference between short- and longer-dated Treasuries -- has been closely-watched as a potential indicator of a looming contraction, investors might do better to watch a measure of the cost of private credit, according to Charles Gave of Gavekal Capital Ltd.

An inverted yield curve is thought to signal the “market rate of interest,” (shorter-term rates) exceeding the “natural rate of interest” (longer government rates), but may not be a good proxy for economic activity given that the government can always borrow, Gave said.

Instead, he suggests looking at the corporate credit market. Here, the U.S. economy’s natural rate could be represented by the yield of a longer-dated, seasoned industrial bond rated Baa by Moody’s, and the market rate by the prime lending rate charged by U.S. banks.

“The private sector yield curve reading stands at zero, or right on the threshold where trouble can be expected to begin,” Gave wrote in a note published on Tuesday. “Should this spread move into negative territory, I would expect a financial accident to occur outside of the U.S., a U.S. recession, or possibly both.”

Either a U.S. recession has taken place within a year of the private sector yield curve inverting, or a “financial accident” has occurred in other economies with currency links to the greenback, according to Gave’s data.

Prime rates below the natural rate of corporate credit have allowed banks to generate “artificial” money, kept “zombie” companies alive, and enabled other corporates to engage in “financial engineering” predicated on cheap borrowing costs that risk toppling over if the curve inverts, Gave said.

Based on this measure, “we are entering dangerous territory,” he concluded. If the private sector curve inverts “zombie companies will fail and capital spending will be cut, as firms move to service debt and repay principal. Workers will get laid off and the economy will move into recession.”